Lack of Commitment, Retroactive Taxation, and Macroeconomic Instability

Retroactive tax legislation is constitutional in most high-income countries. In this paper, we are concerned with the fiscal and macroeconomic consequences stemming from retroactive income taxation. Within the context of a real neoclassical economy, we find that if the government can set taxes retroactively within the fiscal year—or if there is a positive probability that a future government will be able to use retroactive taxation—then there exists a multiplicity of expectations-driven equilibria. In this case, neither fiscal policy nor macroeconomic aggregates are uniquely pinned down by economic fundamentals. Rather, they are determined by expectations about current and future fiscal policies. This implies that the government is a source of macroeconomic instability. In contrast, a constitutional reform banning the government from using retroactive tax legislation would yield a unique equilibrium, thus removing the possibility of expectations-driven fluctuations.